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Bonds

Should they be part of a balanced portfolio

Date of publication - September 2018

Author - Stephen Luwero

Investment involves risk and there will be times when investors face difficult choices. Some commentators think that one of those times is upon us given the ongoing trade war rhetoric, BREXIT and geopolitical instabilities.

To add to this, interest rates are rising in response to an improving global economy coupled with a tick up in inflation and this is putting at risk the capital value of some bond allocations.

More locally, the situation in the UK and Europe is somewhat different and is affected by a number of factors with the rate rise timetable less certain. In the UK for example, the ongoing BREXIT negotiations and the uncertainty this is creating is likely to delay any further interest rate rises until the second half of 2019. Despite this the economy has continued to grow.

Should bond investors worry about rising interest rates?

The fact that yields are rising on bonds should not necessarily lead to negative returns for all concerned as there are options to mitigate risks. Our own Income Portfolio includes the Artemis Strategic Bond fund which recorded a cumulative return in excess of 15% over 3 years to the end of June 2018 despite the rising rates headwind - a good indicator that opportunities still exist in the sector.

For investors, it is a good discipline not to over-react following negative media commentary. By all means review portfolios but for those that do hold or wish to hold bonds the reason for investing in them remains the same - to provide a regular income and reduce overall portfolio risk.

How Bond Managers can adapt in a higher interest rate environment.

Investment managers have several tools at their disposal to mitigate some of the negative implications of rising interest rates. One option is to switch some of the portfolio of bonds to those that provide a higher return especially in periods of low corporate default rates. Bonds of this type are generally issued by companies that find it difficult to obtain finance from markets on preferential terms, offering instead higher yields to attract inward investment from private finance. The downside of switching to lower credit ratings can be that it increases the overall risk level of a balanced portfolio so there is a need to strike a balance.

Another option open to managers is to adjust the duration of a portfolio's bond allocation. Bonds are issued for a fixed term before being redeemed by the issuer whether it be for 1, 3, 5 or 10 years for example. The income (coupon) available is fixed for the duration of the bond. When there is an interest rate rise, bonds issued prior to the rise will offer inferior returns compared to those that are issued after the interest rate rise. The lack of demand impacts on the underlying value of the bond with the price being discounted affecting the valuation. The longer the duration of the bond them ore impacted the value will be. Basically because investors are unwilling to tie money up for a long period of time to receive an inferior rate of return.

Where investment mandates allow, in an increasing interest rate environment, bond managers will seek to dampen interest rate risk buy shortening the average duration of the portfolio. But, there can be hidden consequences to taking such action. Shortening the duration of a bond allocation is likely to mean that the average coupon will fall and the overall volatility of the portfolio could be impacted.

The strategies that active bond managers employ can result in out-performance but a balance has to be struck - too much of a re-adjustment in a rising interest rate environment can lead to higher fees affecting returns. Maintaining a strategic long-term allocation can provide significant benefits.

Bonds are a natural diversifier

Small, low frequency increases in interest rates will have relatively limited impact on bond capital values. The total returns from bond funds should be maintained as the proceeds from bond maturities are reinvested into those offering a higher coupon. The compound effect will appear minimal over the short term but over the long term it will make a considerable difference to maintaining growth.

Perhaps most importantly, bonds offer a diversification from equities that is extremely difficult, if not impossible, to replicate through investment in other asset classes. Investment grade and government bond issues are available with predictable cash flows. Their volatility and cyclical characteristics tend to have a negative correlation to equities that can be invaluable in times of equity market uncertainty.

It is easy to overlook the 'safety net' offered by bonds when equity markets are performing well but it should not be forgotten that markets fall as well as rise - bonds act as a natural diversifier and should not be discounted.

For further details on the investment options available please contact us.

The information in this article was accurate at the date of publication in September 2018.

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